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Stock Market Volatility Transmission in Malaysia: Islamic Versus

Conventional Stock Market

Article · January 2007

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Rosylin mohd. yusof M. Shabri Abd. Majid

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 J.KAU: Islamic Econ., Vol. 20, No. 2, pp: 17-35 (2007 A.D./1428 A.H.)

Stock Market Volatility Transmission in Malaysia:

Islamic Versus Conventional Stock Market
Rosylin Mohd. Yusof ∗ and M. Shabri Abd. Majid ∗∗
F F F

Abstract. This study attempts to explore the extent to which the

conditional volatilities of both conventional and Islamic stock markets
in Malaysia are related to the conditional volatility of monetary policy
variables. Among the monetary policy variables tested in the study are
the narrow money supply (M1), the broad money supply (M2), interest
rates (TBR), exchange rate (MYR), and Industrial Production Index
(IPI), while the Kuala Lumpur Composite Index (KLCI) and Rashid
Hussain Berhad Islamic Index (RHBII) are used as measures for
conventional and Islamic stock markets, respectively. In order to
capture the international influence on both stock markets, the volatility
in the U.S. monetary policy variable measured by the Federal Funds
Rate (FFR) is incorporated into the study. Unlike our earlier study
(Mohd. Yusof and Abd. Majid, 2006) that employed the Generalized
Autoregressive Conditional Heteroskedasticity (GARCH)-M, GARCH
(1,1) framework together with Vector Autoregressive (VAR) analysis
are employed for the monthly data starting from January 1992 to
December 2000 in this study. The study finds that interest rate
volatility affects the conventional stock market volatility but not the
Islamic stock market volatility. This highlights the tenet of Islamic
principles that the interest rate is not a significant variable in
explaining stock market volatility. Our finding provides further support
that stabilizing interest rate would have insignificant impact on the
volatility of the Islamic stock markets.

1. Introduction
The interaction between stock market volatility and macroeconomic variables has
been extensively researched in the financial economics literature. Among the most
pertinent questions raised are: to what extent the explanatory power of monetary policy

∗
Head of the Department of Economics, Kulliyyah of Economics and Management Sciences, International
Islamic University Malaysia.
∗∗
Department of Economics, Kulliyyah of Economics and Management Sciences, International Islamic
University Malaysia.
17
18 Rosylin Mohd. Yusof and M. Shabri Abd. Majid

variables is able to explain the stock market volatility? And the extent to which the
volatility in the international monetary policy transmitted across national stock markets?
Officer (1973), for instance, examines the effects of volatility in business cycle
variables. Black (1976) and Christie (1982) provide empirical evidences on the
relationship between stock market volatility and financial leverage in the U.S. economy.
Kock and Kock (1991), Malliaris and Urrutia (1991), Chan et al. (1992), Peel et al.
(1993) and Rahman and Yung (1994) explore whether the world’s financial and capital
markets are now transmitting volatility more quickly. Studies on volatility of asset
returns have also been documented in the recent years. Examples are Tarhan (1993),
Calvet and Abdul Rahman (1995), Johnson and Jensen (1998) and Ibrahim and Jusoh
(2001).

Several other studies have also examined the causes of stock market volatility
particularly its macroeconomic causes. Schwert (1989) conducts an extensive array of
tests on the macroeconomic causes of stock market volatility over long runs of monthly
data for the United States. Liljeblom and Stenius (1997), Kearney and Daly (1998),
Muradoglu et al. (1999) and Morelli (2002) provide further evidence on the
macroeconomic causes of stock market volatility.

Nevertheless, less empirical evidences are documented on the presence of time-

varying risk premiums in the stock returns. The examples include Stenius (1991) and Su
and Fleisher (1998). By employing GARCH model, Stenius (1991) analyzes the
volatility of stock prices and evaluates whether there exists a relationship between
increased volatility and the risk premium, which investors require in order to maintain
the stocks. Su and Fleisher (1998) also apply the GARCH model to estimate an
empirical model which captures the effects of local and global information variables on
the conditional mean of the stock market excess returns. They also find that the
government’s market intervention policies have significant effect on stock market
volatility in China.

The experience of the stock market volatility in Malaysia has extensively been
highlighted in the recent years. Tang and Garnon (1998) assess the adequacy of the
Exponentially Weighted Moving Average (EWMA) and various GARCH –class models
in predicting volatility in both the Malaysian stock market and individual stocks and at
the same time identify which of these models is most preferred. Ibrahim and Jusoh
(2001) investigate the causes of stock market volatility by employing the Generalized
Least Squares (GLS) estimation together with the Hendry’s general-to-specific based on
the Davidian and Caroll (1987). The finding suggests that among the most important
determinants of the KLCI conditional volatility are the volatilities, lagged money
supply, industrial index and inflation rate. Ibrahim (2002) compares two approaches
namely the moving average standard deviation and ARCH models to examine
relationship between stock market volatility and macroeconomic volatility. He finds that
the presence of unidirectional causality is running from exchange rate volatility and
reserve volatility to stock market volatility. From the above studies, we can conclude
that inconsistent results are obtained with regards to which variables significantly
affects the Malaysian stock market volatility.
 Stock Market Volatility Transmission in Malaysia … 19

While the studies on conventional stock market are proliferating in the recent
decades, less attention is being given to its Islamic counterpart, particularly with regards
to the volatility transmission. For instance, Hakim and Rashidian (2005) explore the risk
and return of the Dow Jones Islamic Market Index (DIJMI) and its parallel conventional
counterpart, Wilshire 5000 Index (W5000). Their findings suggest that the DIJMI
presents unique risk-returns characteristics compared to the risk profile of W5000. In
the Malaysian context, Muhammad (2002) investigates the performances of the KLSE
Composite index, KLSE Syariah index and the RHBI index during the period of 1992-
2000. The study finds that the movements of both the conventional and Islamic indices
are somewhat parallel. By using GARCH-M approach, Mohd. Yusof and Abd. Majid
(2006) compare the risks and returns of the Islamic and conventional stock market
volatilities in Malaysia for the 1992 to 2000. They find that risk as measured by the
conditional standard deviation does not affect stock returns during the period of
analysis. There is no evidence of significant time varying risk premium for both
conventional and Islamic stock returns.

In the light of the above studies, inconsistent results prevail with regards to which
variables significantly affects the Malaysian stock market volatility. Most of the above
reviewed studies contribute to our understanding of the econometric characteristics of
volatility. However, very few provide economic explanation of volatility of stock
returns and underlying causes of the observed volatility in stock returns. Based on our
literature review, there has been no study conducted on the effect of monetary policy
volatility on Islamic stock market volatility in Malaysia using GARCH (1,1)
framework. This study is an extension of our previous paper, Mohd. Yusof and Abd.
Majid (2006). It attempts to fill this gap by exploring the effectiveness of the monetary
policy variables in regulating both conventional and Islamic stock markets in Malaysia.
Successful estimation of the volatility of the underlying stocks in the Malaysian market
will enable investors to make decisions when engaging in dynamic trading strategies.

Therefore, the main objectives of this present study are: (i) to explore the predictive
power of the volatility in each of the monetary policy variable on both conventional and
Islamic stock market volatilities; and (ii) to estimate the relationships between both
conventional and Islamic stock market volatilities and the volatilities of the monetary
policy variables.

The rest of the study is organized in the following manner. In the next section, we
shall highlight the theoretical framework pertaining to the issue of the stock market
volatility. Section 3 provides an overview on the Malaysian stock markets. The
empirical framework in Section 4 highlights the volatility dependencies as captured by
GARCH (1,1) model. Section 5 provides empirical results and discusses the findings
and implications. Finally, the conclusion is presented in the last section.

2. Theoretical Framework
Theories explaining the relationships between stock market volatility and economic
volatility include Simple Discounted Present Value Model (SDPVM), Capital Asset
Pricing Model (CAPM), and Arbitrage Pricing Theory (APT). According to SDPVM,
the stock prices are determined by the future cash flow to the firms and the discounted
20 Rosylin Mohd. Yusof and M. Shabri Abd. Majid

rates. The volatilities in these two factors could be affected by volatility in

macroeconomic variables and in turn, will affect the stock market volatility (Liljeblom
and Stenius, 1997; Ibrahim, 2002; Ibrahim and Jusoh, 2001; and Md. Isa, 1989). This
implies that a change in the level of uncertainty about future macroeconomic conditions
would produce, perhaps a proportional change in stock return volatility assuming that
the discount rate is constant.

The impact of monetary policy can be further analyzed in the following manner:
The price of equity at any point in time is equal to the present value of expected
future cash flows (including capital gains and dividends) to shareholders:

∞
C it + k (X t + k )
E t −1Q it = E t −1 ∑ (2.1)
k =1 (1 + R t + k )k
Where Qit is the price of asset i at time t, Ci denotes the cash flows associated with
asset i, R denotes the interest rate and E t-1 is the expectations operator. In a open
economy and financial system such as in Malaysia, corporate cash flows Ci are
influenced by the development of monetary policy changes, X. Examples of X are level
of M1 and/ or M2 money supply, interest rate (TBR), exchange rate (MYR), real output
(IPI) and foreign monetary policy changes as proxied by the U.S Federal Funds Rate
(FFR), etc.

In moving from equity prices to returns, we can then let the conditional expected
return of the asset on the available information at time t − 1 be denoted by
[ ]
qˆ i t = Et = q i t I t −1 q. Accordingly, we also denote σqit, be the unconditional standard
deviation of return on asset i. While, the conditional standard deviation can be
expressed as σˆ
qi
t [ ]
= Et σ qi t I t −1 . From equation (2.1), the conditional expected return
on asset i is a function, f of the conditionally expected determinants of the discounted
cash flows:

[ ] { [
q̂ i t = E t q i t I t −1 = f E t C it (X ) I t −1 ] } (2.2)

and the conditional standard deviation of returns is a function, of the conditional

standard deviations of the determination of the cash flows

[ qi
]
E t σ t I t −1 = g{E t σ t , σ t [ X R
]I t −1 } (2.3)

In addition, CAPM is also a useful theory in explaining the magnitude of an asset’s

risk premium, the difference between the asset’s expected return and the risk-free
interest rate (Mishkin and Eakins, 1997). Accordingly, Rose (2000) defines the expected
return on a financial asset as:

E(R i ) = rF + β i [E(R M ) − rF ] (2.4)

 Stock Market Volatility Transmission in Malaysia … 21

Where E(Ri) measures the expected return on the i th asset; E(RM) is the expected
return on the market’s entire collection of financial assets or the whole portfolio; β i is a
measure of an individual asset’s or portfolio of asset’s risk exposure compared to the
risk exposure of the whole market portfolio; and rF is the risk-free interest rate (often
approximated by the return on government bonds). The risk-free interest rate element
can be influenced by the changes in money supply and thus affecting the expected
return of a financial asset. Therefore, volatilities in monetary policy variables, may also
affect the volatility in the expected return of a financial asset.

Lastly, capital asset pricing model has also proved to be useful theory in terms of
explaining the source of systematic risk, though it only focuses on the source of risk
available in the market portfolio. In APT models, macroeconomic variables constitute
an important set of information in determining stock prices. Macroeconomic volatilities
are therefore modeled assuming that they influence stock prices via their effects on
future cash flows and the discount rates as evident in the SDPVM.

3. The Malaysian Stock Market

As it is today, the Malaysian stock market is one of the most prominent emerging
markets in the region. 1 The Malaysian Stock Exchange was initially set up in March
F F

1960, and public trading of stocks and shares commenced in May 1960 in the clearing
house of Bank Negara Malaysia. The Capital Issues Committee (CIC) was established
in 1968, to supervise the issue of shares and other securities by companies applying for
listing or already listed on the Exchange. Following the termination of the
interchangeability with Singapore and the floating of the Malaysian dollar, the
Malaysian Stock Exchange was separated into Kuala Lumpur Stock Exchange (KLSE)
and Stock Exchange of Singapore (SES) in 1973.

In 1992, the Islamic Capital Market (ICM) 2 was introduced in the Malaysian
F F

economy. Its existence is reflected by the presence of Islamic stock-broking operations

which include Islamic indices, Islamic unit trusts, and a list of permissible counters in
the KLSE as issued by the Securities Commission (SC). The main feature of ICM is its
activities are guided by Shari’ah injunctions. Precisely, ICM represents an assertion of
religious law in the capital market transactions where the market should be free from the
elements such as usury (riba), gambling (maisir) and uncertainties (gharar).

The Islamic corporate securities market comprises of Islamic debt securities (IDS)
market and the Islamic equity market. Currently, there are two Islamic Indices; the RHB
Islamic Index (RHBII) introduced in 1992 and the KLSE Syariah Index (KLSI)
launched in 1999. Our paper emphasizes on RHBII. When it was first launched, the
RHBII was based on 179 Kuala Lumpur Stock Exchange Main Board counters which
approved by the Shari’ah council of Bank Islam Malaysia Berhad and the Shari’ah
Panel of Rashid Hussain Berhad (RHB). However, as of 1st January 1998, the counter

(1) In comparison with other markets, Malaysia was ranked twenty-third in the world in 2004, being the
largest market in ASEAN and is currently ranked eighth in Asia. If 1996 was used as yardstick, the KLSE
would be one of the largest markets in the world (Bank Negara Malaysia, 2005, pp: 307-310).
(2) See http:// islamic-world.net/Islamic-state/malay_islamcap market.htm.
22 Rosylin Mohd. Yusof and M. Shabri Abd. Majid

for RHBII is based on the companies approved by the Shari’ah Advisory Council of the
Securities Commission and those deemed permissible by the Shari’ah Panel of RHB.
As of October 2000, the total counters listed under RHBII are 316.

On June 23, 2005, the Dow Jones-RHB Islamic Malaysia Index was launched. This
new index was jointly developed by Dow Jones Indexes and RHB Research Institute
Sdn Bhd and replaces the RHB Islamic Index that has been in use since May 1996. The
Index is part of the Dow Jones Islamic Market Index series and follows the
methodology of the Shari’ah compliant index family. The index has been developed
specifically to meet the growing demand for Shari’ah compliant in the Malaysian stock
market. The index is based on internationally acknowledged Islamic finance standards.
A committee consisting of international Shari’ah scholars, the Dow Jones Shari’ah
Supervisory Board, are formed to observe the execution of those standards used by Dow
Jones Indexes.
4. Methodology and Data
4.1. Methodology
This section discusses the statistical tools for analyzing volatility focusing on the
extended GARCH model and VAR analysis. In most empirical works, the GARCH
(p,q) models adopt low orders for the lag lengths p and q, e.g., GARCH (1,1), 3 GARCH F F

(1,2) or GARCH (2,1). Such small numbers of parameters are sufficient to model the
variance dynamics over very long sample periods. This study, therefore, adopts the
GARCH (1,1) model to estimate the relationship between stock market volatility and
the monetary policy volatility. Based on diagnostic tests such as ARCH-LM,
Correlogram-Q Statistics and Durbin-Watson, 4 there are no remaining serial correlation
F F

and misspecification in the mean equation specified by GARCH (1,1).

In this model, both the conditional mean and the conditional variance equations
incorporate monetary policy variables namely M1 and M2 money supply, interest rate
(TBR), exchange rate (MYR), real output (IPI) and federal funds rate (FFR) to measure
foreign monetary policy changes. We can further assess the predictive power of
monetary policy volatility on stock market volatility and vice-versa using the VAR
model. This procedure is conducted firstly for conventional stock market and then
repeated for the Islamic stock market.

4.1.1. GARCH (1,1)

In this analysis we generate the volatility estimates for stock returns and monetary
policy variables growth rates based on the following standard GARCH (1,1)
specifications:
m
Rt = ∑
i =1
αI Rt-1 + δIdi,t + εt (4.1 )

ht2 = β0 +β1 ε 2t-1 + β2h2t-1 (4.2)

(3) Liljeblom and Stenius (1997) states that several empirical studies indicate that GARCH (1,1) model
adequately fits many economic time series, especially the stock return series. See also Bollerslev (1987),
Akgiray (1989) and Bollerslev et al. (1992).
(4) Please refer to Section 5 for results.
 Stock Market Volatility Transmission in Malaysia … 23

whereas for the monetary policy variables induced model, the specification is as
follows:
m
Rxt = ∑
i =1
φ Rxt-i +δIdi + εt (4.3)

hxt2 = β0 +β1 ε 2 x t-1 + β2h x2t-1 (4.4)

The (1,1) in GARCH (1,1) refers to the presence of a first order ARCH term (the
first term in the parentheses) and a first order GARCH term (the second term in
parentheses). An ordinary ARCH model is typically a special case of a GARCH
specification in which there are no lagged forecast variances in the conditional variance
equation.

Having generated the volatility estimates for stock returns and monetary policy
variables growth rates; we next proceed to VAR to test the predictive power of
monetary policy volatility on stock market volatility and vice-versa. Consistent with the
works of Morelli (2002) and Liljeblom and Stenius (1997), a two-variable twelfth-order
VAR model is adopted in our study, as follows:

12 12
h2t = β0 + ∑
i =1
φi h2t-i + ∑
i =1
θi h2 xjt-i + ε t (4.5)

12 12
2
h xjt = β0 + ∑
i =1
2
θih xjt-i + ∑ i =1
φi h2t-i + + ε t (4.6)

where ht2 is the conditional stock market volatility at time t, h2xjt-i is the conditional
volatility in the monetary policy variable j at time t - i, where i = 1, …,2. This enables
us to determine whether conditional stock market volatility can be predicted by
conditional monetary policy volatility or vice-versa. 5 F

4.1.2.Regression Analysis
To further assess the relationship between stock market volatility and monetary
policy volatility, we conduct regression analysis for both conventional and Islamic stock
markets based on the following empirical models:

Conventional Stock Market:

0BU

Model 1: Ln KLCIt = α0 + α1 Ln M1t + α2 Ln IPI t + α 3 MYR t +

α4 Ln TBR t + α 5 FFR t + πt (4.7)

Model 2: Ln KLCIt = δ0 + δ1 Ln M2t + δ2 Ln IPI t + δ 3 MYR t +

δ4 Ln TBR t + δ 5 FFR t + τt (4.8)
U

(5) According to Morelli (2002), this two-variable VAR model allows us to capture historical patterns of each
variable and its relationship to the other; generally used to forecast values of two or more variables.
24 Rosylin Mohd. Yusof and M. Shabri Abd. Majid

Islamic Stock Market:

Model 1: Ln RHBIIt = β0 + β1 Ln M1t + β2 Ln IPI t + β 3 MYR t +
β4 Ln TBR t + β 5 FFR t + εt (4.9)
Model 2: Ln RHBIIt = λ0 + λ1 Ln M2t + λ2 Ln IPI t + λ 3 MYR t +
λ4 Ln TBR t + λ 5 FFR t + μt (4.10)

As highlighted in the above models, in Model 1, narrow money supply (M1) is used
as the monetary policy variable, while Model 2 uses broad money supply (M2).
Accordingly, the rest of the monetary policy variables remain unchanged. The choice of
monetary policy variables above are motivated by the relevance and importance for the
Malaysian economy during the period of analysis (Mohd. Yusof, 2003).

In this study, we hypothesize that there will not be significant differences in the
reaction of stock returns volatility to macroeconomic volatility as compared to the
conventional stock returns volatility. Accordingly, we postulate that variables such as
narrow money supply (M1), broad money supply (M2) and Industrial Production Index
(IPI) will have similar effects in terms of direction on both Islamic and conventional
stock markets. However, as highlighted in the Shari’ah principles, the Islamic stock
market volatility is not influenced by interest rate volatility as interest rate is deemed not
permissible.

4.2. Data
The study utilizes monthly data covering the period 1992 to 2000. The data is
gathered from Bank Negara (the Central Bank of Malaysia) reports and Bloomberg
Database. Kuala Lumpur Composite Index (KLCI) and Rashid Hussain Berhad Islamic
Index (RHBII) are used as measures for conventional and Islamic stock markets,
respectively. Both measures of money, that is the narrow measure of money (M1) and
broad measure of money (M2), Treasury Bill Rate (TBR), exchange rate (MYR)
represent monetary policy variables used in this study. Industrial Product Index (IPI) is
used as a proxy for real output. 6 Finally to test for the international influence on the
F F

volatility of stock returns, we also include the variable Federal Funds Rate (FFR).
Except for TBR and FFR, logarithmic differences are taken of the monetary policy
variables in order to measure growth rates in M1, M2, MYR and IPI.
In this study, volatility is defined as the variance of stock returns. The stock returns
are calculated as the log of the price relative: 7 F

P ⎞
Rt = ln⎛⎜ t ⎟ (4.11)
⎝ Pt −1 ⎠
Where Pt is the index value of stock at the end of month t and Pt - 1 is the index
value of stock for previous month-end, t - 1.

(6) This is not uncommon as several studies on the Malaysian stock market volatility also include Industrial
Production Index as a determinant (Ibrahim and Jusoh, 2001; Tang and Garnon 1998; and Ibrahim,
2002).
(7) Note that the return is not adjusted for dividend yield. This is not uncommon despite the fact that the
dividend is a component of stock returns (Ibrahim, 1997).
 Stock Market Volatility Transmission in Malaysia … 25

5. Empirical Results
In this section, the summary statistics for stock returns, growth rates for the
monetary policy variables and the conditional volatility estimates are presented. The
study, then discusses the empirical results based on GARCH (1,1) specification. Here,
we highlight various relationships between the growth rates of the monetary policy
variables and the stock returns behaviour. Finally, study highlights the results for our
VAR analysis where the relationship between monetary policy variable volatility and
stock market volatility is discussed.

5.1. Summary Statistics

Table 1 provides summary or descriptive statistics for our main variables namely
RHBII, KLCI, M1, M2, TBR, MYR and FFR. The first column reports the name of the
variable, while the rest of the columns report the test statistics including the mean,
standard deviation, skewness, kurtosis, Ljung–Box Q Statistics test for autocorrelation,
and Jarque-Bera (1980) test for normality.

As observed in Table 1, the RHBII yields a higher average monthly return (0.4%)
than the KLCI (0.2%). Except for TBR that has negative average growth (4.4%), the
other variables have a positive average growth rates ranging from 0.3% to 2.2% per
month. The FFR monthly growth rate is recorded as the highest (2.2%). It is interesting
to note that both the RHBII and KLCI have similar volatility as indicated by their
similar standard deviation of 0.097. At this juncture, this suggests that investing in
Islamic stocks provides higher returns although it has almost similar risk to the
conventional stock market.

Except for growth rates of stock indices (RHBII and KLCI) and M2 money supply,
all variables are negatively skewed. In terms of kurtosis value, except for IPI, all the
variables are found to have excess kurtosis (greater than 3). This is expected for most
financial time series distributions. Results from the autocorrelation tests up to 12 lags
indicate that autocorrelation exists. In addition, the Jarque-Bera (JB) normality test
indicates that we can reject the null hypothesis that the residuals are normally
distributed. Finally, the significances of r1, r2, r3, r6, r12 and Ljung-Box Q statistics tests,
indicate the presence of autocorrelation (error terms are not white noise).
26 Rosylin Mohd. Yusof and M. Shabri Abd. Majid

Table (1)
 Stock Market Volatility Transmission in Malaysia … 27

5.2. Analysis for GARCH (1,1)

The GARCH (1,1) approach is employed to generate the volatility estimates for
stock returns and other monetary policy variables. Table 2 reports the GARCH (1,1)
specification described in equations 4.1 and 4.2 for conventional and Islamic stock
markets, respectively. For the lags considered, the Ljung-Box Q-statistics indicate that
we cannot reject the null hypothesis of the presence of no autocorrelation at 5%
significance level. This implies that the mean equation is not misspecified for both
conventional and Islamic stock returns. Further, we found both past returns and the
1997 financial crisis have no effect on the stock returns (as described in the mean
equation). This could possibly be attributed to the government’s fixed exchange rate
policy in cushioning off the effect of the 1997 financial crisis. However, the lagged
value of the conditional variance in the variance equation is found to be positive and
statistically significant for both markets. The sum of the coefficients is 0.987 for
conventional stock market and is 0.926 for Islamic stock market (which is less than
unity) and therefore satisfies the non-explosiveness of the conditional variances.

Table (2). GARCH (1,1) Model Estimates for Stock Returns.

2B

Conventional
Islamic Stock Return
Stock Return
0.012 -0.036
α1 (0.923) (0.777)
-0.0004 0.008
δ1
(0.986) (0.685)
3B

0.0004 0.0008
β0 (0.123) (0.221)
0.245 0.219
β1 (0.053) (0.154)
0.742 0.707
β2 (0.000) (0.000)
Skewness
4B 0.007 5B -0.272
6B

Kurtosis 7B 4.259 8B 3.950 9B

Normality
10B 7.007 1B 5.296 12B

16.605 13.572
Ljung-Box Q(12)
(0.165) (0.329)
13B

14B 15B

31.835 25.394
Q(24)
(0.131) (0.385)
16B

17B 18B

41.909 34.033
Q(36)
(0.230) (0.562)
19B

20B 21B

( β1 + β 2 ) 0.987
2B 0.926
23B

Durbin-Watson 1.973 24B 1.977 25B

F-Stats:
26B F-Stats:
0.766 1.134
(0.599) (0.349)
ARCH LM
Observed-R2: Observed-R2:
4.707 6.816
(0.582)27B (0.338)

Next, Table 3 reports the GARCH (1,1) specifications based on equations 4.3 and
4.4. As noted, except for M2 and IPI, for all the monetary policy variables, both the
lagged values of the squared residuals and lagged values of the conditional variances in
the variance equations are found to be statistically significant. The sum of the
coefficients for the lagged values of the squared residuals and the lagged values of the
28 Rosylin Mohd. Yusof and M. Shabri Abd. Majid

conditional variances are 0.971, 0.376, 0.508, 1.068, 1.016 and 0.970 for M1, M2, IPI,
TBR, MYR and FFR respectively. In general, volatilities in all the monetary policy
variables indicate the non-explosiveness of the monetary policy variances.

Table (3). GARCH (1,1) Model Estimates for Stock Returns (With Monetary Policy
28B

Variables Specifications).
M1 29B M2 30B IPI 31B TBR 32B MYR 3B FFR 34B

0.054 0.265 -0.419 0.298 0.296 0.254

δ1
(0.219) (0.026) (0.000) (0.006) (0.003) (0.000)
35B

0.014 0.007 0.012 -0.021 -0.000 0.018

Ф
36B

(0.017) (0.223) (0.179) (0.856) (0.993) (0.473)

β0 0.000
(0.000)
0.000
(0.344)
0.001
(0.329)
0.009
(0.002)
0.000
(0.000)
0.000
(0.149)
β1 -0.088
(0.000)
0.149
(0.304)
0.203
(0.226)
0.392
(0.000)
0.556
(0.000)
-0.087
(0.003)
β2 1.059
(0.000)
0.227
(0.751)
0.305
(0.539)
0.676
(0.000)
0.460
(0.000)
1.057
(0.000)
Skewness
37B -0.425
38B 0.16739B -0.44840B -1.053 41B 1.285 42B -0.018
43B

Kurtosis 4B 3.526 45B 3.47246B 3.260 47B 7.426 48B 10.559 49B 3.469 50B

Normality
51B 4.416 52B 1.48053B 3.847 54B 106.103
5B 281.506
56B 0.977 57B

30.081 20.506 61.963 12.882 8.5838 14.899

Ljung-Box Q(12)
(0.003) (0.058) (0.000) (0.378) (0.738) (0.247)
58B

59B 60B 61B 62B 63B 64B

46.197 32.681 95.752 21.526 21.764 31.007

Q(24)
(0.004) (0.111) (0.000) (0.608) (0.593) (0.154)
65B

6B 67B 68B 69B 70B 71B

67.708 44.944 113.60 36.859 33.866 43.280

Q(36)
(0.001) (0.146) (0.000) (0.429) (0.570) (0.188)
72B

73B 74B 75B 76B 7B 78B

( β1 + β 2 ) 0.971
79B 0.376
80B 0.508
81B 1.068
82B 1.016
83B 0.970
84B

Durbin-Watson 1.965 2.027 85B 86B 1.998 87B 2.001 8B 2.003 89B 1.999 90B

F-Stats: F-Stats: 91B F-Stats:

92B F-Stats:
93B F-Stats:
94B F-Stats:
95B

0.565 0.934 0.652 1.407 0.253 0.540

(0.757) (0.475) (0.688) (0.220) (0.957) (0.776)
ARCH LM 2
Obs*R : Obs*R2: Obs*R2: Obs*R2: Obs*R2: Obs*R2:
3.515827 5.681 4.039 8.322 1.608 3.367
(0.742) (0.460)
96B 97B (0.671)
98B (0.215) 9B (0.952) 10B (0.762)
10B

Note: Obs*R2 represents observed R2

5.3. VAR Analysis

By using VAR framework, we then proceed with the analysis to assess the
predictive power of the volatility in each of the monetary policy variable on stock
market volatility and at the same time, enable us to estimate the predictive power of
stock market volatility in explaining the volatility of each of the monetary policy
variable. In this analysis, we start by determining the stationarity of the variance series
generated based on the GARCH (1,1) specifications. Vector Autoregressive Analysis
(VAR) requires that the data is stationary in order to avoid spurious regression.
Therefore, we conduct the ADF unit root tests on the specified variance series. Our
ADF unit root tests indicate that three variables; RHBII, KLCI and M1 are not
stationary at levels while the other variables are found to be stationary at levels (See
Appendix I). However, all variables are found to be stationary at first difference. Based
on these results, we therefore choose the first differenced variables in our following
analysis.

The VAR allows us to examine the effects of monetary policy volatility on stock
returns volatility. Here, the predictive power of monetary policy volatility is obtained by
 Stock Market Volatility Transmission in Malaysia … 29

regressing the stock returns with monetary policy variable (one by one based on 12th
order VAR Model) with stock returns volatility as the dependent variable. Whereas, to
assess the predictive power of stock market volatility in predicting monetary policy
volatility, the same procedure is employed with monetary policy variable volatility as
the dependent variable as in equations 4.5 and 4.6.

Table (4). F-Tests from Vector Autoregressive Models for Stock Returns Volatility Including M1, M2,
102B

IP, TBR, MYR and FFR Volatility, 1992-2000.

M1 M2 IPI TBR MYR FFR

Conventional Stock Market
Predictive power of monetary 3.707 2.887 1.707 2.175 2.036 0.886
policy volatility (0.000) (0.000) (0.045) (0.007) (0.012) (0.618)
Predictive power of stock 1.462 1.792 2.674 1.839 1.687 0.978
market volatility (0.113) (0.032) (0.000) (0.026) (0.048) (0.504)
Islamic Stock Market
Predictive power of
3.556 3.510 2.746 2.819 3.510 1.159
monetary policy
(0.000) (0.000) (0.001) (0.000) (0.000) (0.310)
volatility
Predictive power of
1.504 2.059 2.536 2.247 2.103 1.184
Islamic stock market
(0.097) (0.011) (0.001) (0.005) (0.009) (0.288)
volatility
Note: figures in parentheses represent the probabilities (p-values)

From Table (4), except for FFR, we find that the volatilities of all the monetary
policy variables chosen have an influence on the stock market volatility for both the
conventional and Islamic markets in Malaysia during the period 1992-2000. However, it
is interesting to note that the predictive power of monetary policy variables volatility
appear to better explain the volatility in Islamic stock market. This could perhaps be due
partly to the number of listed companies under Islamic stock market is smaller as
compared to the conventional stock market.

These findings provide several important policy implications. Malaysia, being an

emerging market is more susceptible to the increased volatilities in monetary policy
variables. The bidirectional causation running from all the monetary policy variables
volatility and both the conventional and Islamic stock markets underlines the
importance of monetary stability. This could be explained by the ‘substitution’ between
monetary assets and financial assets during periods of high volatility. This further
implies that stabilizing the monetary aggregates and interest rate will reduce the
volatility in the both conventional and Islamic stock markets.

Based on the above discussion, the findings also suggest that exchange rates
together with interest rates and money supply M1 and M2 appear to be the appropriate
targets for the government to affect both the conventional and Islamic stock markets in
Malaysia during the period of analysis. Our results are in line with the finding of
Ibrahim (2002) for exchange rate volatility and at the same time contradict the finding
of Ibrahim and Jusoh (2001) who found no evidence for exchange rate and interest rate
volatilities on conventional stock market volatility during the period October 1992 to
December 1999. At this juncture, our findings support the government’s policy to focus
on exchange rate to stabilize the stock market during the period of the 1997 financial
crisis.
30 Rosylin Mohd. Yusof and M. Shabri Abd. Majid

5.4. Regression Analysis

In this section, we present the regression analysis results based on the empirical
models, equations 4.7 to 4.10. Based on Table 5, for both models using M1 and M2, the
volatilities in exchange rate and interest rate significantly affect the conventional stock
market volatility during the period of analysis. This augurs well with the stock valuation
model which views that stock prices represent the discounted present values of the
firm’s future cash flows. An increase in the interest rate, for example, reduces stock
prices and eventually the returns. Investors who seek to maximize profits tend to be
more sensitive towards changes in interest rates. Accordingly, instability caused in the
conventional stock market during the period of analysis is mainly caused by the changes
in the interest rates. Perhaps, the government should emphasize on controlling the
interest rate to stabilize the conventional stock market. This finding is consistent with
the study by Muradoglu et al. (1999) who found that for Turkish stock market, higher
interest rate affect the stock market volatility for the period 1988-1995.
Interestingly, for the Islamic stock market, interest rate is found to be insignificant
for both models. This highlights the tenet of Islamic principles that the interest rate is
not a significant variable in explaining stock market volatility. It is found that 22-29%
of the volatilities in the monetary policy variables can predict conventional stock market
volatility. Whereas, for the Islamic stock market, the predictive power of the monetary
policy volatility reduces from 15-26% with the volatility in exchange rate remain the
most significant. For Muslim investors, they are not just concerned about maximizing
profits but also whether the stocks are Shari’ah compliant. This concurs with Webley et
al. (2001) and Etzioni (1988) who view that there has been a marked growth in the
literature recently that investors seek to go beyond maximizing profits and that they are
more concerned of the moral dimension of their investments. In the case of Malaysian
investors who seek to invest in Shari’ah compliant stocks, interest rate is therefore not a
determining factor. In addition, for Islamic stock market volatility, a different variable is
found to be the important indicator of stock market instability, namely the exchange
rate. As elaborated by Liljelblom and Stenius (1997), the stock returns volatility should
depend on the health of the economy. Hence, it is plausible that a change in the level of
uncertainty about future macroeconomic conditions like exchange rate would produce
perhaps a change in stock return volatility. Accordingly, economic factor like exchange
rate significantly affects the Malaysian stock market volatility rather than interest rate
alone. For the government agencies, these variables should be noted in designing
policies to stabilize both conventional and Islamic stock markets.
Table (5). Regression Analysis of Stock Market Volatility on Monetary Policy Volatility.
Constant
103B M1 M2 IPI MYR TBR FFR R2
Conventional Stock Market
0.000 -2.848*** -1.267** 0.872*** 0.003** 0.091
- 0.287
(0.301) (-3.221) (-2.003) (5.151) (2.224) (1.013)
0.000 -3.041 -1.094 0.819*** 0.003* 0.102 0.220
(0.166) (-1.015) (-1.659) (4.597) (1.788) (1.078)
Islamic Stock Market
0.000 -2.948*** -1.121** 0.630*** 0.001 0.090 0.259
-
(0.296) (-3.882) (-2.063) (4.335) (1.025) (1.164)
0.000 -1.391 -0.942 0.589*** 0.000 0.098
- 0.149
(0.138) (-0.527) (-1.622) (3.754) (0.439) (1.178)
Note: ***, **, and * represent 1%, 5%, and 10% level of significances.
Figures in parentheses denote the t-statistics.
 Stock Market Volatility Transmission in Malaysia … 31

This finding reveals higher explanatory power than the studies on the U.S. and U.K.
stock markets. Schwert (1989) for instance, by using U.S data, showed a weak evidence
(an explanatory power of between 2.2% and 5%) that macroeconomic volatility namely
inflation, industrial production and money can help predict stock return volatility.
Morelli (2002) found that for UK data, only 4.4% of the variation of the stock market
volatility is explained by macroeconomic volatility i.e., exchange rate, industrial
production, inflation, real retail sales and money. A study by Liljeblom and Stenius
(1997) based on Finnish data indicated higher explanatory power of the macroeconomic
volatility. Lilijeblom and Stenius (1997) found that between one-sixth and more than
two thirds of changes in the conditional stock market volatility are affected by
macroeconomic volatility namely inflation, industrial production and money supply.

6. Conclusion
This study attempts to establish the link between the monetary policy volatilities
with the volatility of stock returns in both conventional and Islamic stock markets in
Malaysia during the period January 1992 to December 2000. To capture the link
between monetary policy variables and the Malaysian stock market volatility, the
GARCH (1,1) model is employed. The study suggests that the predictive power of
monetary policy variables volatility appear to better explain the volatility in Islamic
stock market. This could perhaps be due partly to the number of listed companies under
Islamic stock market is smaller as compared to the conventional stock market. As
expected, the study finds that the interest rate volatility affects the conventional stock
market volatility but not the Islamic stock market volatility. This highlights the tenet of
Islamic principles that the interest rate is not a significant variable in explaining stock
market volatility. These results suggest that interest rate volatility acts as an important
indicator of economic instability and therefore increases the conventional stock market
volatility during this period. However, for Islamic stock market volatility, a different
variable is found to be the important indicator of economic instability, namely the
exchange rate. This implies that the Islamic stock market is less susceptible to
volatilities in monetary policy variables as compared to the conventional stock market.
Additionally, based on the Malaysian experience, it is also important to note that
interest rate volatility is much more difficult to control, given the competitive nature of
the financial and banking systems as compared to volatilities in exchange rate.

The results of this study provide important policy implications for the domestic
stock markets and international investors. Firstly, the fact that volatility persistence is
high should be taken into consideration by the investors in the portfolio management
with regards to asset returns predictability. For the policy makers, to curb the outflows
of capital as a result of higher volatility or risk can be controlled by stabilizing the
exchange rates as well as the interest rates. However, one should also caution that,
combinations of other policies also be required to curb the outflows of capital due to
higher volatility. This finding also supports the government’s move to peg the exchange
rate in order to curb the capital outflows during the 1997 financial crisis.
32 Rosylin Mohd. Yusof and M. Shabri Abd. Majid

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34 Rosylin Mohd. Yusof and M. Shabri Abd. Majid

APPENDIX (I)
Unit Root Test of Volatility Estimates Based on GARCH (1,1) Specifications

Level First Difference

Variable:
ADF PP ADF PP
Intercept -2.330 -2.125 -9.041*** -12.243***
KLCI
Trend & Intercept -2.315 -2.132 -9.066*** -12.400***

Intercept -2.408 -2.327 -5.169*** -12.635***

RHBII
Trend & Intercept -2.359 -2.258 -5.187*** -12.497***

Intercept -2.345 -2.363 -10.763*** -10.821***

M1
Trend & Intercept -2.473 -2.335 -10.726*** -10.789***

Intercept -6.352*** -6.227*** -8.174*** -34.066***

M2
Trend & Intercept -6.360*** -6.232*** -8.135*** -33.912***

Intercept -6.906*** -6.902*** -6.493*** -21.508***

IPI
Trend & Intercept -6.912*** -6.912*** -6.496*** -21.213***

Intercept -3.325** -3.314** -9.160*** -11.325***

TBR
Trend & Intercept -3.323* -3.325* -9.132*** -11.286***

Intercept -4.618*** -4.591*** -7.438*** -36.632***

MYR
Trend & Intercept -4.652*** -4.632*** -7.407*** -38.872***

Intercept -2.029 -1.985 -5.069*** -10.728***

FFR
Trend & Intercept -2.664 -2.440 -5.063*** -10.696***

Note: ***, **, and * represent 1%, 5%, and 10% levels of significances.
 Stock Market Volatility Transmission in Malaysia … 35

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